Intrastate Crowdfunding and the 499 Shareholder Problem

In prior posts I have lamented the problems with the federal crowdfunding law. The SEC is still behind on finalizing rules implementing the crowdfunding provisions of the JOBS Act. In the meantime, Washington State and a handful of other states have pushed forward with crowdfunding laws of their own that are meant to offer a less expensive and more practical and usable alternative to the federal crowdfunding law.

The Basis of State Crowdfunding – The Intrastate Exemption

State-level equity crowdfunding laws allow a company to equity crowdfund without having to comply with the federal crowdfunding law. To accomplish this, states designed their equity crowdfunding laws that rely on the intrastate exemption from registration under the Securities Act of 1933 (the “33 Act”).

Section 3(a)(11) of the 33 Act exempts from registration any security that is part of an offering sold only to persons residing within a single state if the company is also doing business in that state. So, as long as a company complies with the federal intrastate exemption, it only needs to be concerned with the state’s crowdfunding rules when conducting a crowdfunding offering; it won’t also have to comply with the federal crowdfunding law.

The 12(g) Issue

Although state crowdfunding laws make it easier for a company to crowdfund (so long as the company complies with the intrastate exemption), companies need to watch out for other federal laws that can trigger reporting requirements. One of the more historically notorious rules is Section 12(g) of the Securities Exchange Act of 1934 (the “Exchange Act”).

Section 12(g) of the Exchange Act requires a company to register its securities with the SEC if the company has (A) more than $10 million in assets and (B) a class of securities that is held by either 2,000 persons or 500 persons who are not accredited investors.

So if a crowdfunded company has equity investments from 500 persons who are not accredited investors or from over 2000 persons (whether accredited or unaccredited), the company may be required to start filing expensive periodic reports with the SEC and go through the full expense and rigmarole of being a public company.

Some Recent History on 12(g)

Section 12(g) has also been called the “Facebook Rule” because of Facebook’s widely-reported on experience with the rule.

The JOBS Act made Section 12(g) was made less onerous: Section 12(g) used to require that if a company had more than 500 shareholders of record (whether accredited or unaccredited) and over $10 million in assets, the company would need to register with the SEC (the idea being that there was an active trading market for a company with more than 500 shareholders and investors needed to be protected ). The JOBS Act increased this threshold so that a company needs to register only if it has either 2,000 or more shareholders of record in total or 500 or more unaccredited shareholders and over $10 million in assets.

Even with the amendments from the JOBS Act, however, because the 500 threshold for unaccredited shareholders remains, this rule remains a potential barrier to companies hoping to access state-level equity crowdfunding statutes without having to comply with significant regulatory obligations and expense.

Does Federal Crowdfunding Have the Same Problem?

No, the federal crowdfunding exemption avoids the 12(g) problem: Based on the SEC’s proposed rules, persons holding securities issued under the federal crowdfunding exemption will be exempted from the calculation of the number of shareholders of record under 12(g). See page 275 and following of the proposed Crowdfunding rules.

Practical Advice and Suggestions

Below are some tips and advice for avoiding accidentally surpassing the 12(g) cap:

Obtain and keep good documentation showing the accredited investor status of investors (if they are accredited).

Conclusion and Grounds for Optimism

Intrastate crowdfunding has hope. We need the SEC to fix its overly restrictive Compliance & Disclosure Interpretations. See The SEC Needs To Fix Its Intrastate Crowdfunding Guidance. And we may need the Congress to amend Section 12(g) to accommodate larger intrastate crowdfunding offerings. But, even if the SEC doesn’t back off its C&DIs, and Congress does nothing more to Section 12(g), state-level equity crowdfunding should still be helpful to companies.

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About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.

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